Why Trading Rarely Works

The simple reason short-term trading rarely works? You have a brain.

But wait, you say, isn’t that an advantage? No, because your brain isn’t designed for trading, it’s designed for survival. You aren’t built to be a rational, calculator of outcomes; that’s why we invented computers. Emotions are controlled by hope, greed, fear, love, confusion; and emotions tend to control actions.

The study of financial psychology basically exists to create a long list of reasons that human brain fails at investing and trading. Every investor should know and understand these hard-wired quirks that keep us alive in the wild but returns down in the market.

Loss Aversion: A loss is twice as painful as a gain. A 5% gain doesn’t create an equal emotional reaction as a 5% loss. Rationally and mathematically this shouldn’t make sense but humans are made to avoid losses. This is not a bad trait but it doesn’t apply well to trading.

Sunk Cost Effect: People tend to treat spent money as more valuable than money in reserve. Poker players know this effect well. After pushing so many chips to see an unhelpful flop, a player finds it difficult to fold because capitol is already committed. We find it hard to let go of an investment even when the odds are stacked against us.

Disposition Effect: Traders tend to takes gains and let losses run. A quick 20% return makes most people sell and realize the quick gain even if the long-term prospects are just as good. A slow decline in price can suck a trader in and trick them into hoping for a turn around when the evidence isn’t there. We fear realizing a loss, making it permanent. We hope it turns around.

Outcome Bias: Improperly judging a decision based on gain or loss and not the QUALITY OF DECISION. The future is unknowable. The outcome is decided by the unknowable future, therefore judging the outcome is based on judging unknowable events. The only constant that can be judged is YOUR decision making process.

Recency Bias: The tendency to weigh recent data/outcomes more heavily than past data/outcomes. Losses this week effect actions more than gains from last month.

Anchoring: Relying to heavily on readily available information. This causes people to hold on too long or stay out too long.

Bandwagoning: Believing in things that the crowd hold as truths. The cause of bubbles.